Executive Salaries; H. Sennholz

EXECUTIVE SALARIES t'J JJan~ :J.. Senn~olz A FAVORITE point of attack against capitalism is the im pressive height of the salaries of top business executives. Labor union leaders especially tend to be critical of ex ecutive salaries and bonuses amounting to a hundred thousand dollars or more. People unfamiliar with the principles that determine wage and salary rates are apt to become envious and receptive to ideas that are hostile to our free economy. The selection. of corporate management confronts stockholders with choices similar to those we all must face in our daily purchase decisions. Should they look for management at bargain rates? Should they shop for medium-priced management, or search for the best possi ble men who demand top salaries? As in everyday life, the best is often the cheapest in the long run. The stockholder must hire the men who do the actual work for him. He is aware that the mistakes of corporate executives can consume a large percentage of net income or even eliminate it altogether. On the other hand, the right men may earn large profits and greatly enhance the value of the corporation. Depending on the size of the business, the selection of management may mean a differ308 EXECUTIVE SALARIES 309 ence of millions of dollars in profits or losses, which em..

phasizes the importance of the right management. In the history of the automobile industry the stock .. holders of dozens of independent companies had this choice to make. Many of them chose management at bar.. gain rates-and lost their investments when the com.. panies fell by the wayside. The managerial salaries in those cases, no matter how low, proved to be no bargains after all. At the same time, the obscure and failing Max.. well-Chalmers Corporation hired Walter P. Chrysler who built it into one of the big three of the industry. His compensation, no matter how high, constituted a real bargain to the corporate owners. Not only the owners but also the workers gain from superior management. Contrary to much union propa ganda, the workers' interests are served best under su perior management. Wages tend to be higher in a profit able and expanding enterprise than in a failing one. Fringe benefits are higher and jobs more secure. Rejoic ing about cheap management can be very shortsighted and shortlived.

Finally, there are the consumers who, indirectly at least, demand efficient management. Production efficiency makes for better and cheaper products which can meet the pressures of competition. The important problem of executive remuneration is to attract and hold the best men. The value of a com pany is determined by the men who run it and work for it. The corporation need not necessarily pay the total amount which good management adds to net worth.

310 HANS F. SENNHOLZ What must be paid to attract and hold the men may constitute merely a fraction of the amount they actually earn for the corporation. Corporations Compete for Management In bidding for managerial services in the executive labor market, each corporation acts in competition not only with all other existing corporations but also with the opportunities for the manager to organiz~ a business of his own. Of course, this competition is reflected not only in salaries but also in pensions, bonuses, and other benefits. And the calculations are in terms of net salaries and net benefits after taxes. In order to attract a man from other employment a corporation usually must outbid its corporate competi tors. And in order to hold its man the corporation must pay him at least as much as he could earn in other em ployment. To move from one employment to another involves a serious decision. It often entails a change of residence which is both inconvenient and costly. The home may have to be sold, perhaps at a loss. Children may have to change schools, and many other problems arise through resettlement. It is obvious that the net inducement in the form of higher salary or advancement must be great enough to exceed the disadvantages of such a move.

Let us assume that a net salary improvement of $5,000 annually will induce an executive to move to a different community to work for a different company. And assume EXECUTIVE SALARIES 311 further that the man is in the 80 per cent income tax bracket. Therefore, his $5,000 net raise will cost the com pany $25,000, with $20,000 going to the government and $5,000 to the executive. If he should be in the 90 per cent tax bracket, the corporation would have ~to boost his gross salary by $50,000 in order to attract him. The ques tion is whether or not the new executive will add at least the gross amount of his remuneration to the company output. A skilled executive who adds millions to the net worth of his company undoubtedly meets this condition. The large salary figures often criticized by labor union leaders are the inevitable result of the progressive taxa tion of large incomes. Without this taxation the net sal ary that suffices to attract and hold the executive would constitute the total salary. The government share in the executive salary would remain in the company as profit.

Of course, such an economy without income taxes would allow rapid capital accumulation and business expansion which in turn would intensify corporate bidding for ex ecutives and thus raise their remunerations. But it is doubtful that salaries soon would reach the present fig.. ures which are so largely conditioned by progressive taxation. We are assuming here that capable executives who are the entrepreneurs in a corporation add far more to the output of the business than their own employment costs. This assumption seems justified in the light of corporate experience. Walter P.Chrysler's salary, for instance, un doubtedly was merely a fraction of the net worth he added to the company.

312 HANS F. SENNHOLZ As we have said, competition largely determines how much the corporation has to pay for a good manager. When an executive is hired, his future contribution can merely be estimated. Economic prudence therefore re quires that he be paid merely the amount that suffices to induce him to accept employment. This minimum is determined by competition in the executive labor mar ket. Once he proves to be a capable entrepreneur who adds profits to the company, his remuneration tends to go up. For the corporation now must increase his remu neration lest he accept employment with a competitor who also recognizes his ability to create profits. To avoid the leverage effect of confiscatory taxation on executive salaries, often involving tax rates higher than the corporation otherwise would have to pay on profits, many companies resort to forms of remuneration that are taxed at lower rates. For instance, they may grant purchase options that give executives the right to buy from the company a certain number of shares of stock at prices that are lower than the market price. Besides the tax advantage, this method has an additional attrac tion. The executive becomes co-owner, giving him new in centives for doing his utmost in the service of the company.

The upper limit of an executive salary ultimately is determined by the profits which his employment yields to the company. The executive's productive contribution minus his employment costs constitute this profit on his employment. This explains why an executive is apt to be replaced as soon as another executive can be found whose EXECUTIVE SALARIES 313 productive contribution minus his employment costs yields a larger profit to the company. The new man may be more productive for the same money, or equally pro ductive for less money, or in some other way afford the company the maximum profits on his employment, which is the major factor that determines the executive selection. Of course, these economic principles of the determina tion of executive salaries are moderated and may be frus trated by personal factors, such as ignorance, inertia, friendship, hopes and illusions, and other feelings.

The Case of Poor Management We have been discussing superior management and its compensation, but must not neglect the cases of poor management which undoubtedly exist. Inferior manage ment is apt to make costly mistakes and inadvertently inflict losses on the company. It is obvious that the serv ices of such executives are not worth the salaries they are paid. In other words, their productive contributions are worth less than their costs. Prudent corporate own ers will dismiss them without delay. To unseat an inefficient management of a huge cor poration is difficult when hundreds of thousands of stockholders are involved. It may be that no one man or group owns enough shares to exert working control. In this case, stockholders seem to have only the choice of selling their securities. Such selling or shunning of shares may resul t for the time being in lower price-earnings 314 HANS F. SENNHOLZ ratios and higher yields on the stock. But in that event, various promoters and speculators may see an oppor tunity for unseating the inefficient executives through soliciting the support of dissatisfied stockholders. They wage costly proxy fights and occasionally succeed in ob taining working control.

But modern interventionism with its confiscatory tax ation even hampers this last safeguard for efficient man agement. Proxy fights are very costly. Without assurance o£ success they may consume hundreds of thousands of dollars of a man's own funds. Few men still can dare to lose these sums for the sake of corporate control, the eventual fruits of which they must again share with the government. Therefore, proxy fights have become rela tively infrequent, and inefficient management may stay in office indefinitely. Thus does interventionist govern ment encourage and perpetuate inefficient management. Executive salaries ultimately are determined and paid by the consumers. Through buying or abstention from buying, consumers determine which corporations are to earn profits or suffer losses. They determine the remu neration of Frank Sinatra, Marilyn Monroe, and Rocky Marciano. And they also determine and pay the workers' wages as well as the executive salaries at General Motors and U.S. Steel.